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saxobank: Outlook 2008 Year of recession

Outlook 2008
Year of recession

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saxobank: Outlook 2008 Year of recession

2008 Outlook: Year of recession

Welcome to our outlook for the global economy and our predicted developments for
the major global asset classes for the coming 12 months. Our key findings are:

Macroeconomic Trends
• Due to the collapse of the US housing market, a slowing growth rate and increasing inflation,
which will shut down the possibility for further rate cuts by the FED, we forecast that the US
economy will enter recession.

• The UK is lagging behind the US economy and consequently we will most likely see a development
similar to the one we have just experienced in the US. The housing market will deteriorate;
interest rates will be cut further and we will see rising inflation.

• The Eurozone looks like a slow, but steady performer. But the Eurozone economy is still
dependent on the US economy and consequently we expect a general weakness. ECB will most
likely take rates to 4.25% in early 2008 and unemployment will begin to increase due to
weakening exports.

• We forecast three hikes in Japan in 2008 taking interest rates to 1.25%. On this move of rates
towards normalisation we will most likely see capital inflows into Japan and this will benefit
Japanese assets – both equities and home prices (but not bonds). The sun should be creeping
slowly higher in Japan again.

• We believe that oil should go higher as we expect many of the current drivers of higher energy
prices to continue. We consider this scenario as the most likely even though we expect demand
from developed countries to drop due to slowing economies.

• Agricultural products will go higher in 2008 even though they may be trading lower in the first
half of 2008. With fuel ethanol as a new demand driver for corn and China and India continuing
to increase their demand for agricultural products prices will go higher. And this is rather certain
since the supply side is close to being constant on a short term.

FX markets
• 2007 was definitely the year for the EUR, but despite economic conditions remaining firm we
expect that we have seen tops both against the USD, CHF and JPY. Our Q4 forecast for EURUSD is

• A rise in JPY should come from further risk aversion. We are not at all impressed by macro-
economic data coming out of Japan that puts little pressure on the BoJ to hike rates in 2008. Our
Q4-forecast for USDJPY is 111.00 with the real profit potential lying in EURJPY where our forecast
is 149.00

• Despite most market participants liking the CHF it has not been able to get its funding currency
label, but in 2008 we might see it move in the right direction. Our Q4 forecast for EURCHF is

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saxobank: Outlook 2008 Year of recession

• We believe SEK and NOK will continue to be stronger and we look for EURSEK to test 8.80
and EURNOK to test 7.75 by Q4 2008.

• AUD and NZD looked to have topped – seen both from a rate outlook and from the investors’ risk
appetite perspective. We forecast AUDUSD to 0.76 and NZDUSD to 0.62

• We think that CAD will loose strength through 2008 and our forecast for USDCAD is 1.06 with
the potential or the currency being sold the heaviest against the CHF. But for commodity
currencies we still expect CAD to outperform AUD.

• Our GBP 6-month view remains clear, but with some upside risk to inflation in the remainder
of the year. Our Q4 forecast for GBPUSD is 1.90, with CHF being a potential big gainer against the
pound through the first half of 2008.

• How equities will fare in 2008 will almost certainly depend on which way the macro picture
unravels. Our macro view prescribes recession and this will bring the major indices down by 15-

• We continue to believe in China’s long-term macro and microeconomic potential. However,

looking into 2008 for Chinese equities, we see a turning point where risks are overshadowing
fundamentals. We forecast a correction of 40% in Shanghai Composite Index, targeting 2900 year

• Even though Japanese equity markets have been a living nightmare for long-only investors the last
two years we believe that Japan could be up for a positive surprise given a mild recession. We will
buy at 13352.

• With a recession looming which should dampen growth we advise the long only investor to enter
defensive stocks in sectors like healthcare, oil services and insurance and telecom. Due to the
circumstances with increasing prices in grain we recommend long positions in equities related to
agricultural production.

The Saxo Bank Market Strategy Team,

Copenhagen, 07 January 2008.

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saxobank: Outlook 2008 Year of recession

2008 Outlook: Year of recession............................................................................2

Saxo Bank’s Outrageous Predictions of 2008.......................................................6

1) Ron Paul elected President of the United States......................................................6

2) S&P500 falls 25% from its 2007 high to 1182........................................................6
3) EURSEK falls to 8.8000 (now 9.4000)....................................................................7
4) USDSGD falls to 1.4000, but then rises back to 1.6000 (now 1.6000).....................7
5) EURHUF rises to 275 ............................................................................................7
6) At least three of the largest 10 US homebuilders will go bankrupt..........................7
7) Chinese stock market falls 40% by late summer.....................................................8
8) Grain prices to double – again!.............................................................................8
9) World oil prices accelerate to $175........................................................................9
10) UK growth turns negative...................................................................................9

Recapping our 2007 portfolio.................................................................................10

2008 top picks............................................................................................................11

Short GBPCHF..........................................................................................................11
Long NOK and SEK vs. EUR (½ each)..........................................................................11
Short Avalon Bay Communities..................................................................................11
Short Nippon Express Co. LTC....................................................................................11
Long Helmerich & Payne...........................................................................................11
Long DS Norden.......................................................................................................11
Long PowerShares DB Agriculture Fund.....................................................................11
Long Nikkei / Short Nasdaq 100.................................................................................12
Long TRYISK.............................................................................................................12
Long EURHUF...........................................................................................................12

2008 – The Year of Recession....................................................................................13

Mega-Trend Reversal – From credit creation to “forced savings”.................................13

The market is getting tired of risk..............................................................................13
Stagflation is back!...................................................................................................14
Key lessons from faltering housing markets................................................................16
Housing’s impact on Industrial vs. Emerging Markets..................................................17

The US economy in 2008 – recession as expected..................................................18

The European Economy in 2008 – Subprime contagion to take a hold..............19

UK especially vulnerable to global financial turmoil....................................................19

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saxobank: Outlook 2008 Year of recession

The Japanese Economy in 2008 – is the sun finally rising again?........................20

Energy in 2008: Oil Prices Could Double Again to 175 USD/barrel......................21

Booming demand in oil exporting economies ............................................................21

Peak oil....................................................................................................................21
Emerging markets demand growth – particularly in India and China............................23
Natural Gas: the Weather Joker.................................................................................23
The Usual Suspects...................................................................................................23
Downside Risks.........................................................................................................23
We like crude oil in 2008..........................................................................................24

Agricultural Outlook 2008 . ..................................................................................25

Outlook for FX markets 2008..................................................................................26

SEK and NOK to continue stronger............................................................................26

AUD and NZD reaching cyclical highs in 2007............................................................26
CAD to loose strength through 2008.........................................................................27
Our GBP 6-month view remains clear but…...............................................................27
CHF finally looks ready to leave its label….................................................................28
A rise in JPY should come from further risk aversion...................................................28
EUR: The 2007 steamroller looks to be running out of gas..........................................29
The dollar outlook remains uncertain, but…...............................................................29
Growth engines charging from East...........................................................................30
Emerging building bricks beyond the BRICs . .............................................................30
Yield spreads growing between emerged and emerging markets................................31
Expect higher volatility in riskier investments..............................................................31

Equities 2008: At the very end of the cycle...........................................................33

Stick to Defensive Sectors ........................................................................................34

The Support for US Military at an end - focus on Lockheed Martin..............................34
Alternative Energy....................................................................................................35
Bearish but neutral on financials................................................................................36
Japan – Time to shine?..............................................................................................36
China – Bubble bursting?..........................................................................................37
Agricultural products – prices keeps going up............................................................37

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saxobank: Outlook 2008 Year of recession

Saxo Bank’s Outrageous Predictions of 2008

If you’ve been reading Saxo Bank’s yearly outlooks for the last few years, you’ll know
to look out for this one – our annual attempt to predict the black swan sightings in
global markets for the coming year. Remember that these predictions are made more
in an attempt to provoke thought than any attempt at accuracy. Also, our predictions
are unfortunately a bit on the down side this year – so let’s hope that we’re very wrong
the most doomy and gloomiest of them. This year, we have again asked for the opinion
of our clients about the Outrageous Claims. These results are mentioned below each
Outrageous Claim.

1) Ron Paul elected President of the United States

We’re starting with the most outrageous first! One would imagine that a party with the least popular
president to inhabit the White House – ever – wouldn’t stand a snowball’s chance in Texas of getting a
new candidate elected to the presidency. But Ron Paul is no George Bush Jr., even if he is a Republican like
Bush and is from Texas like Bush. His libertarian, anti-war platform is about three standard deviations away
from the platform of any other Republican candidate — or even Hilary Clinton, for that matter. Paul’s share
in the Republican candidate polls has rocketed from 1 % to 6% in the space of a few months and there
is the best part of a year to go until the election. As should be clear from this year’s Outlook, we are quite
negative on the US economy in 2008. A general slowdown and stock market turmoil should increase the
odds of a Ron Paul nomination as he has been the only candidate to speak frankly about the budget and
current account deficits and the dollar crisis.

Client agree/disagree ratio = 0.68 (555 yes, 813 no). This is apparently the claim that is most
outrageous according to our clients. That said, a ratio of 0.68 as the worst/lowest indicates that
we have not been outrageous enough in our claims for 2008.

2) S&P500 falls 25% from its 2007 high to 1182

Why 1182? That would be an exact 25% drop from the 1576 high the S&P500 index reached in mid-
October of this year. History shows that a stock market drops 15-30% when housing markets fail. “Easy
Al Greenspan” and “the slice and dice any manner of junk and pass on the risk to your clients” investment
banking paradigm triggered the biggest housing bubble in US history. The unwind from the height has
already been severe – by some measures the most severe since the Great Depression – but it has further
to go. So we are daring to forecast that the fall in the major US index would lie at the extreme end of the
scale before we see the light at the end of the tunnel.

Client agree/disagree ratio = 1.87 (793 yes, 423 no). Our clients are pretty bearish on Equities, it
seems. Good thing, we are primarily an FX house!

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saxobank: Outlook 2008 Year of recession

3) EURSEK falls to 8.8000 (now 9.4000)

In 2007, the SEK was a currency of many stripes. First, it was on a weak footing as the carry trade was in
focus, and its low interest rate attracted interest in selling SEK as a funding currency. Then the Riksbank
moved rates onto parity with the ECB for the first time in over two years and many speculated that it
could become an even higher yielder. But then a few weakish numbers from Sweden and a bout of risk
aversion have put the SEK on a weak footing as 2007 draws to a close. But we believe that 2008 could
be a stellar year for the currency as the still new government’s continued, more liberal-minded policy
initiatives support capital inflows and also because rate differentials offer relative support for SEK. As
an added bonus, the country sports one of Europe’s largest current account surpluses as measured by
percentage of GDP.

Client agree/disagree ratio = 1.66 (634 yes, 382 no). It seems that our SEK bullish coverage over
the past few months is paying off...

4) USDSGD falls to 1.4000, but then rises back to 1.6000 (now 1.6000)
The beginning of the righting of global imbalances has meant a stronger Singapore dollar over the last
year. The Monetary Authority of Singapore (MAS) has allowed SGD to strengthen to help ease the pressure
caused by strong capital inflows and inflation and as the country registered robust growth rates. This
process could continue for a while into 2008 and take USDSGD toward 1.4000, but eventually the pair
could rise sharply as Singapore has already taken a large share of the necessary adjustment to reflect
global imbalances. SGD could also weaken as capital flows ease sharply and possibly even reverse when
the market looks at the odds for a global growth slowdown and as Singapore’s own sovereign wealth fund
continues to look for overseas investments as a way to recycle its massive reserves.

Client agree/disagree ratio = 1.36 (521 yes, 383 no). Our clients do not really buy into this story.
Perhaps this is due to the generally bearish USD sentiment.

5) EURHUF rises to 275

The Hungarian Forint is on our watchlist of currencies that could really suffer if we see a slowdown in
global growth and a move to risk aversion in 2008. Some analysts are looking for a stronger Forint if the
Hungarian central bank is forced to ditch the band it allows the HUF to trade in against the EUR (this
may happen as EURHUF has declined close to the lower margin of the band and because risk appetite
in emerging markets has remained relatively high while FX volatility has spiked in 2008). A slowdown in
global growth could punish Hungary’s export-driven growth, while a lack of risk appetite could force the
HUF to weaken in light of the country’s massive budget deficit. These factors could see EURHUF rise some
10% from current levels to 275 in a hurry.

Client agree/disagree ratio = 2.23 (563 yes, 253 no). The HUF is generally being recognised as one
of the most risky EM FX plays. It is simply not worth the yield.

6) At least three of the largest 10 US homebuilders will go bankrupt

As 2007 draws to a close, many of the stocks for the largest home construction outfits in the US are rallying
after Bush rolled out his desperate attempt to stem the subprime tidal wave by fiddling with rate reset
mechanisms and implementing other measures that all seem like pumping medicine into a dead horse.
These measures are too little and too late, as the last phases of the US housing boom were one of the worst
examples of overextension by any industry ever – driven by excess liquidity (see S&P500 prediction above).
Why is it that we think we need to abolish the economic cycle? The unwind of this bubble will continue

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saxobank: Outlook 2008 Year of recession

and we think at least three of the largest US homebuilders could go bankrupt in 2008. If you are reluctant
to go short stocks on this story, find companies that specialise in legal services. Why? This situation has the
potential for endless lawsuits as this legal precedent-setting legislative proposal is guaranteed to produce
a feeding frenzy for lawyers if no one else… To save you a bit of time, the tickers for the largest ten US
home builders, as of this writing, are DHI, TOL, CTX, PHM, NVR, LEN, KBH, RYL, BHS, and MTH.

Client agree/disagree ratio = 2.74 (811 yes, 296 no). No doubt, the bearish sentiment on house
prices and housing stocks will continue. A considerable part of this year’s Yearly Outlook is tied
up on such an outcome.

7) Chinese stock market falls 40% by late summer

The Chinese stock market bubble in 2007 saw one of the most remarkable accumulations of paper wealth
in financial market history. The rise in Chinese equities is certainly due in part to solid fundamental
underpinnings, including a liberalisation of markets and remarkable economic growth. But there are a
number of factors that we believe may have resulted in an unhealthy overextension in equity prices that
could mean an ugly correction in 2008 – possibly around the psychologically important 2008 Summer
Olympics in Beijing. So what will provide the trigger for a sell-off? First, Chinese officialdom is showing
an increasing willingness to clamp down on excessive growth with liquidity tightening. Second, some of
the “fundamentals” in earnings are really a pyramiding of stock market gains as companies have booked
profits stemming from stock market gains! Also, much of the bubble has been caused by capital controls
that have kept too much liquidity bottled up in the domestic market. Signs are that those controls may
be eased significantly to allow domestic capital to flow abroad and ease this pressure. So the Shanghai
composite could fall as much as 40% or more in 2008. Look to buy any excessive fallout, however!

Client agree/disagree ratio = 1.30 (636 yes, 489 no). Worries about a correction in China are
looming and a 40% correction is not perceived as especially unrealistic. Let’s see what happens
after the Olympics.

8) Grain prices to double – again!

2007 saw the most spectacular gains in the grains complex in recent memory as wheat prices doubled
and soybean prices rose to levels not seen since the wild grain markets of the 1970s. The story of grains
is a simple one of supply and demand. Human population growth has slowed on a percentage basis, but
per capita consumption of grain is accelerating as emerging markets switch to higher protein diets, which
have a multiplier effect on the grain market. Every kilogram of beef requires 7 kilos of feed, for example.
Chinese meat consumption has doubled per capita since 1990 and milk consumption has tripled since
2000. Most of the world that can be put to the till has been – this means that only pricing can stem
demand in this most inelastic of all markets. Add to this the ethanol phenomenon, which many view as
stealing food from people and putting into petrol tanks (watch for a growing ethics crisis in 2008 as the
“starving stomachs vs. SUVs” debate grabs headlines). In short, the average price for the grains complex
(Corn, Wheat and Soybeans) could double after having already doubled in the last 15 months. For those
who would rather not trade grain futures, have a look at the ETF called the PowerShares DB Agriculture

Client agree/disagree ratio = 1.75 (672 yes, 383 no). We are surprised to see how many agree
with us on this. A re-doubling of grains prices would be a really big surprise and the chances of
it actually happening are closely related to the oil prices (below).

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saxobank: Outlook 2008 Year of recession

9) World oil prices accelerate to $175

Much of the conventional wisdom on oil has been proven wrong over the past few years, as previously
unimaginable new highs in the price of oil have only been a reflection of the strength of global growth,
rather than an obstruction in its path. And with the weak USD and shrinking profit margins for refiners,
the end consumer in many places throughout the world hasn’t noticed a difference between oil prices
at 99 dollars compared to oil prices at 75 dollars. Even if global growth slows in 2008, it will continue to
move ahead in the emerging markets of the world where marginal energy demand is growing the most.
As “peak oil” becomes a widely accepted principle and supply and demand do a nervous dance, the price
risk in energy remains firmly to the upside.

Client agree/disagree ratio = 0.78 (503 yes, 648 no). Why not? So far, the world economy is
coping relatively well with rising energy prices. But apparently, it is hard to pursuade our clients
of a re-doubling of energy prices.

10) UK growth turns negative

The UK economy may go into a nosedive in 2008, weighed down by some of the same factors that have
toppled the US. The UK housing bubble is possibly worse than the US bubble and has only begun to
unwind. The Bank of England (BOE) has dragged its feet as the credit crisis has unfolded, which could
worsen the situation compared with the FED, where “Helicopter Ben” has replaced “Easy Al”. The UK
consumer is even more overextended in terms of all forms of debt than his US counterpart. Need we say
more? Okay, we will: the UK terms of trade are awful and getting worse and its most important industry
– financial services – is likely to see its worst recession since the internet/telco blowup of 2000-1. By Q3,
UK GDP growth may flop into the negative column.

Client agree/disagree ratio = 2.08 (718 yes, 345 no). Perhaps just a case of general bearishness
among our clients. In fact, we might have gotten the same kind of answer for the Swiss or South
African economy?

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saxobank: Outlook 2008 Year of recession

Recapping our 2007 portfolio

In 2007, we tried to pick stocks with strong valuations and growth. Somewhat conservative stocks were
chosen. Again we were bullish on precious metals and crude oil, in addition we were bullish on Scandies
(short USDNOK and short NZDSEK).

Our equity portion of the portfolio returned a modest combined 4.5% mostly helped by being long
Humana, it was a rough year to be an equity investor. What shined in last year’s portfolio was our call for
long, silver, gold and crude oil; however, our call for higher oil prices in 2007 started off under considerable
amounts of pressure as crude slid to around $50 a barrel. But after January Crude had a strong year almost
reaching $100 a barrel.

In addition we take pride in our short USDNOK call. We expected Norges Bank to send rates to 5.0% and
the Fed cutting to 4.0%. Deposit Rates in Norway are now 5.25% and the Fed Funds rate has been cut to
4.25% this has caused the pair to see a continued downwards slide throughout the year.

As we mentioned earlier, our Yearly Outlook is intended more to induce thought than to make a return.
After all, we are pretty much abstaining from a dynamic approach by choosing a fixed composition of the
portfolio at year’s end and we usually don’t make changes throughout the year.

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saxobank: Outlook 2008 Year of recession

2008 top picks

We recommend taking a 10 percent position in each of these assets

Play the downside with options, using a risk reversal strategy.  The view through 2007 that the Swiss
franc continues to be relatively weak as a ‘funding currency’ still sticks, and going forward we see yield
differentials favouring the currency especially against the euro and sterling. Fundamentals remain firm and
with inflation in our view likely to surprise to the upside – supported by the recent strength in imported
goods along with one of the largest surpluses in the world – we see the CHF remaining firm through

Long NOK and SEK vs. EUR (½ each)

Scandies set to outperform any major European currency.  In our 2007 Outlook, we called for stronger
Scandies and we will maintain this view as the fundamentals still are in place. Both Norway and Sweden have
raised rates and the outlook for stronger rate differentials supporting the Scandies against the majors is
in our mind very likely. Very  tight labour markets adding pressure on pricing and although growth has
showed signs of decreasing, the outlook is stronger than for the majors.

Short Avalon Bay Communities

Globally the housing market is slumping. We believe this will continue throughout 2008 and consequently
we are shorting Avalonbay whose assets will deteriorate as house prices continue their decline in the US.

Short Nippon Express Co. LTC

Since we have named 2008 the year of recession we imply a belief that the economy will slow down.
According to the Dow Theory this will first be reflected in a slowdown in the transporting business. Nippon
Express Co. is a prime pick for being short in this sector.

Long Helmerich & Payne

We apply a bullish view on crude oil in 2008. Oil drilling companies should benefit from this since the
search and drilling for new oil reserves will increase due to the increase in the oil price. We like the outlook
and valuations for Helmerich & Payne in this sector.

Long DS Norden
The situation in the bulk carriers market is that the shipping companies are not able to meet the demand.
And this is not going to change in 2008 since the delivery of new ships that will make the supply
increase significantly will first start in 2009. Thus, bulk shipping will be about the only strong part of

Long PowerShares DB Agriculture Fund

The agricultural prices are going higher due to increased demand from other usages than food. And this is
most likely to continue in 2008 and at least until another input source for fuel ethanol has been invented.
Another driver for higher agricultural prices is continued strong growth in Emerging Markets.

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saxobank: Outlook 2008 Year of recession

Long Nikkei / Short Nasdaq 100

Earnings expectations for Nasdaq are way too optimistic (approximately +75% for 2008 vs. 2007) and
for Nikkei they are way too pessimistic (approximately -75% for 2008 vs. 2007). With a negative outlook
for the US economy and total investment growth usually turning negative in the aftermath of a peak in
housing prices, we recommend being short Nasdaq and long Nikkei for the entire 2008. We also like the
implicit currency exposure in the trade.

We are more bearish on ISK than we are bullish on TRY, but being long TRYISK is about the only way
you can be short ISK without having the carry against you. The Icelandic economy is overheating and
money supply figures are exploding. It looks like one, big leveraged bubble and due to the large size of
its financial sector relative to GDP, Iceland is exposed to a continuation of the subprime problems. While
Turkey is risky itself, its financial sector is somewhat less developed and therefore less exposed to collapse
than Iceland. Additionally, in times of Carry Trade unwinding, TRYISK performs relatively well.

Hungarian forint, which currently trades within a trading band, will be allowed to float freely as the band
will come under increasing speculative pressure, making it difficult/costly for the bank to maintain it. The
abolishment of the band will cause, at first, a sudden HUF appreciation, likely to take the EURHUF towards
the lower end of the current band. This appreciation, however, will be short-lived as the comparatively weak
Hungarian fundamentals will couple with global slowdown, exposing HUF to sharp risk reversals.

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saxobank: Outlook 2008 Year of recession

2008 – The Year of Recession

In 2006, we called our Yearly Outlook “The Year of Consolidation”, the Yearly Outlook for 2007 was
called “The Year of Deceleration” and now we believe the Western world is headed for a recession. Or
rather: The Western world is slowly but surely sliding into the recession that began in 2000, when the
stock markets burst.

The fact that we have been spending three Yearly Outlooks to describe the general deceleration and
slowdown of the Western economies should be viewed as evidence of our impression that we are
witnessing the conclusion of a very big trend in the global economy. We might call that a mega-trend,
since it encompasses both cyclical lows and highs in the economies and is driven by long-term changes to
our culture and notably our perception about the need for savings and consumption.

Mega-Trend Reversal – From credit creation to “forced savings”

The big mega-trend, that is about to come to an end, has debt-financing, inflation, credit creation and
financial engineering as its hallmarks. At all times of history, central banks have been acting irresponsibly;
stating one thing (that they wanted to keep inflation under control), but doing another (supporting stabile
inflation of at least 1 percent). But ever since the abolition of the remnants of the Gold Standard in 1971,
central banks have taken this irresponsibility to new highs, accelerating credit creation, debt-financing
and inflationary forces with the willing help from politicians that in turn manipulate inflation measures
(especially so in the US) and deregulated the financial sector to enable even faster credit growth.

G7 Combined Budget Deficit to GDP, %

























The market is getting tired of risk

As the chart above shows, it is more a rule than the exception that G7 countries are debt-financing. The
millennium-spike was more a result of taxes on maxed-out liquidity-induced transaction volume than
sound public finances and it is increasingly apparent that we are now back to business as usual.

It was all about keeping the good times going via more of the same – cheap credit. Central bankers,
politicians and bureaucrats have done everything they possibly could to stimulate consumer demand,

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saxobank: Outlook 2008 Year of recession

corporate earnings growth and debt-financing, but now one giant problem is showing up in money
markets: Banks are simply not willing to take the added liquidity and push it to borrowers – risk/reward
as a financial mediator has simply deteriorated too much due to the flood of liquidity from the past

Credit Risk Spread (USD Libor Fix - 3 month Treasury Bill)
































In other words, assets are overvalued and credit risk is too dominant.

For these reasons, the theme that will increasingly take over the decades old credit-creation theme will
be one of what we would call “forced savings”. For decades, now, the US (and Western) consumers and
governments have been living beyond their means. Now, they will have to live below their means, since
investments will be punished by asset deflation. Investors will have no place to go – perhaps except in
sovereign fixed income.

In our opinion “forced savings” will come about due to the following reasons. 1) High inflation, additionally
eroding the purchasing power of consumers. 2) Much tighter lending standards, forcing consumers to
make bigger down-payments when, for example, purchasing a home. 3) Higher, effective market rates,
making it less attractive to debt-finance and more attractive to put money in the bank. 4) There will be no
sure trends in big asset classes – i.e. no continuation of the bubblemanias of the past decade, thus giving
no obvious target for eventual excess funds except savings and paying off debt.

Stagflation is back!
The ghost of the seventies is revisiting town due to the complacent central bank attitudes around the
world. For too long, they have allowed money supply figures to increase at a too high pace and interest
rates have been too low.

The natural outcome in an unregulated economy based on private property rights is a light deflation (1-3%
per year), reflecting the productivity gains and competition that is the natural order in private industry.
When central banks then are implicitly or explicitly targeting a positive inflation of 1-3%, they have to
overcome the difference of around 4% between the natural outcome and the central bank induced

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saxobank: Outlook 2008 Year of recession

They can only do this by consistently keeping rates artificially low, thereby stimulating more debt-financing,
more investments and more consumption than would have otherwise existed. But by doing this, they are
punishing savings. Nobody wants to save/forego consumption if the compensation is a ridiculously low
interest rate.

The continuous intervention in the interest rate market then has a price: The lack of savings that should
have met the demand for real resources from the increased investment and consumption simply doesn’t
exist (no saving has been going on) and that is the reason for increased inflation. Businesses compete for
the scarcer-than-expected resources and that pushes prices higher. Rates then have to go higher to reflect
the inflation and the higher risks. That is exactly what is happening now.

G20-countries GDP-weighted CPI
























Looking at above chart, it is clear that headline inflation is no longer in control. The usual myopic focus on
core inflation and blatant disregarding of headline inflation is about to be dropped by central banks.

Asian economies have kept their currencies artificially low vs. Western economies, which have boosted
their export sectors, but reinvoked inflation. They are now exporting inflation to the West and it might
get even worse.

Global labour markets are tight and getting tighter. Capacity utilisations rates are high and Producer Prices
are exploding. Central banks have to do something now or they will lose the battle against inflation for the
next decade. The problem is that they will be too reluctant, since they are still focusing on “stimulating”
the softening demand and trying to pump liquidity out in the markets. The “flation”-part of the subtitle
is then explained, but what about the “stag”-part?

The rationale for a lot of the investments that have been initiated in the past couple of years were build on
assumptions for continuously low interest rates and for continued, strong personal consumption growth.
That is not possible in an environment shifting towards “forced savings” as outlined above and a reduction
of risk-appetite. Consumption is already scaled back and earnings growth in the S&P500 is hitting single
digit levels YoY for the first time since 2003. All in all, GDP growth will moderate dramatically to reflect
the new “forced savings” paradigm.

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saxobank: Outlook 2008 Year of recession

Key lessons from faltering housing markets

During the past two decades, global economies have become even more intertwined
and the correlation between industrialised countries’ housing markets has gone
towards 1. When assessing the health and state of the global economy, it has thus
become even more important to take into account the very significant deceleration of
regional (global) housing markets. This is one of the two most determining factors for
the global economy over the next two years – the other one being secular Emerging
Market growth. We consider the first one (peaking housing markets) to be a decisively
deflationary factor and the second one (Emerging Market growth) to be a persistently
inflationary factor.

It is quite rare that housing markets are topping out and begin to fall. When it happens, however, it usually
has an immense impact on key macroeconomic variables lasting several years.

Judging from historical experiences with faltering housing markets in 30 countries since 1970 and their
subsequent broad economy recessions, we can expect the following from the economies that have seen
their housing markets top out during 2006-07:

• Policy Rates usually peak 3 quarters after the top in the housing market. Then policy
rates continue to fall for several years. This is already happening in the US, which from a
business cycle perspective is more “mature” than the Eurozone economy and other Western
markets. We expect especially the Bank of England to be cutting rates throughout 2008, but also
the ECB will have to moderate monetary policy towards the dovish side. Only Switzerland will
still be hiking.

• This is a result of the fact that the rate of inflation usually also peaks 3 quarters after
a top in the housing market. Then inflation continues to decrease for several years.
Inflation is already moderating slightly in the US, however not at the rate that policy makers feel
comfortable with. Make no mistake; central banks are no longer in control of inflation. We expect
inflation to stay high enough to be troubling throughout 2008. Especially Asian economies and
strong Emerging Market growth are forcing input and energy costs higher. At the same time,
wages are at high, double-digit growth in especially China.

• Real GDP Growth slows and ultimately turns negative 5 quarters after home prices have
topped. GDP growth only normalises after 4 or 5 years. Until now, GDP growth has been
stunningly strong, taking into account the fact that housing markets have topped in most Western
economies. This is very much at odds with historical data. GDP growth has been supported by
high personal consumption growth in most regions, but this now seems too moderate. In the US,
government spending has been a strong supporter as well.

• Real Consumption Growth slows to a total standstill 5 quarters after home prices have
topped out and don’t return to normal until 4 or 5 years after the top in housing. We
are now, finally, seeing marked slowdown in consumer spending and construction activities in all
Western countries.

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• Total Investment Growth turns negative after only 1-3 quarters subsequent to the peak
in home prices and hit a yearly growth of -7 percent 5 quarters after house prices have
topped. Total Investment Growth does not normalise until 5 years after the peak in
home prices. Although investment growth has apparently topped out in 2006, it is still quite
positive. This is also the reason for the very upbeat expectations for Nasdaq100 earnings growth.
Someone will get disappointed.

• Real Long-Term Interest Rates are usually not much affected. After a moderate initial
increase in the first year after the housing market top, they usually begin falling
moderately in the next three years. Already now we are seeing long interest rates going a
lot lower, pricing in a recessionary outcome in the US. We expect the European long-dated fixed
income to follow suit.

• The Unemployment Rate usually increases by at least 40 percent over the subsequent
two years from the housing market peak. In periods with low unemployment rates (like
now), the rate climbs by 80-100 percent. This historical evidence is probably the explanation
for the fact that the Fed has been expecting the unemployment rate to increase for the past year.
But it didn’t begin to increase until half a year ago.

Housing’s impact on Industrial vs. Emerging Markets

It is a central theme in this year’s Outlook that the housing market deceleration experienced in all Western
economies will be a very decisive factor for the macroeconomic development. Historical experiences are
very stable and we can’t see why the historical correlations between the housing markets and macro-
economic variables should have changed fundamentally. Only one thing stands out and could explain
why things seem to play out a bit slower than they have done in the past four decades: that the financial
industry has gone to excesses. Financial engineering, lending standards, appraisal standards, credit
creation, debt-financing have all gone to extremes and helped to prolong (and ultimately worsen) a cycle
that should have turned negative years ago.

Make no mistake, this is a global phenomenon, but it is worst in the economies with the most “mature”
(read: bold) financial sectors – i.e. in the US, UK and Eurozone.

In short, we believe that the industrialised economies should continue to underperform and that the yield
spread vs. Emerging Markets should widen, favouring Carry Trades (see the FX part in this publication) that
nonetheless will continue to experience considerable volatility in 2008.

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saxobank: Outlook 2008 Year of recession

The US economy in 2008

– recession as expected

Is the worst over yet? No, but it is getting priced into a lot of assets – except stocks.
Interest rate products all price in a recession. It more or less looks like 2006 where
stocks continued to go higher, while the yield curve inverted and everybody (including
us) expected a recession in 2007.

But how long is the inevitable postponed? Only as long as the FED and the US government are able to foster
accelerating credit creation and risk willingness. The US economy (and most other industrialised economies)
has become addicted to credit and the monetary aggregates needed to accelerate at exponential rates in
order to keep corporate income growth and real GDP growth up. That is no longer happening.

In this sense, 2007 has been a turning point in the expansion since 2002, since banks are no longer willing
to act as intermediaries of financial risk. Their shareholder equity has become negligible relative to the risk
that the FED wants them to take. Although it is presidential election year and the Bush-administration will
do whatever it takes to pull it off in November, they will not manage to keep up appearances. This will
become obvious by the fall of 2008, where seasonality in the housing market should have dictated higher
prices, but where home owners yet another year will experience shrinking home equities.

Here are some key events that we expect to take place in the US during 2008:

• The savings as a percent of personal income will finally increase after having hit a rock-bottom low
of zero percent in the past couple of years (down from around 10 percent in the mid-1980s).

• Military costs in the Middle East and elsewhere total at least 3.5 trillion dollars since 2001 – or
almost 25 percent of yearly GDP. Costs have to be cut. Troops will be pulled home from Iraq – but
not all (except if Ron Paul is elected president).

• The FED’s Funds Rate should be cut to 3.75 percent and persistent inflation will forbid any further
cuts. This will not matter anyway, since the banking system has grown tired of risk. The FED
has landed in the “liquidity trap” and they are now pushing on a string when they are trying
to add liquidity to the economy through the banking system (see the earlier graph; “Credit Risk

• Headline inflation should retreat, but will still range between 2 and 3 percent, since Asian countries
have now begun exporting inflation and since agricultural and energy products will continue to
rise. Core inflation will stay above 2 percent YoY, thus making further cuts impossible.

• GDP growth should be negative from Q2 or Q3. Business demand will decelerate rapidly and private
consumption will be scaled-down. Personal Consumption Growth will also slow dramatically.

• 10-year rates should fall moderately and will range between 3 and 4 percent for the whole year.
Inflation will still be a problem and we expect the disparity of headline and core inflation to
become even worse, which will add volatility to fixed income.

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The European Economy in 2008

– Subprime contagion to take a hold

Again, this year, the Eurozone looks like the slow but steady performer. The worst
financial excesses have been avoided – except in Spain, where construction activities
have exploded and in the UK, where the financial sector has been just as “innovative”
as in the US. But the rest of Europe is more about a refined division of labour after
the inclusion of the Eastern European countries with their strong growth and cheap
labour. We especially like the new members of the European Union, Poland, The Czech
Republic and the Slovak Republic (see the Emerging Markets part of the publication).

The ECB is still “vigilant” despite not hiking rates in the second half of 2007. We expect that they will take
rates to 4.25 percent in early 2008, but for political reasons the subprime contagion will not allow higher
rates and there will be a loud and annoying choir calling for lower rates.

The Eurozone economy is still dependent on the US economy and we therefore expect a general weakness
to manifest itself around mid-year – especially due to the weak USD. Problems will, however not be as
severe for the entire Eurozone economy as for the US economy.

The unemployment rate will finally begin to increase again due to weakening exports and this will cause
additional worries about the state of the European property market.

UK especially vulnerable to global financial turmoil

In the case of the UK, it seems that the strong and positive trends in financial markets have been a
significant and unexpected support for the housing market. This is now coming to an end. Bonuses will
be moderate compared to prior years and the Northern Rock debacle shows that UK home owners are
vulnerable to shocks. UK home prices are still increasing, but it now seems that they are about to retrace
from the current levels and will most likely follow the American housing market – down.

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The Japanese Economy in 2008 – is the sun

finally rising again?
For many years, analysts and investors have been hoping for Japan to return to the ranks of global
growth drivers. The really big and important question is if 2008 will be the year when Japan finally takes
a seat in the growth bus (that is itself slowing!). Although total Japanese mortgage debt is only worth
around 30% of GDP, that is a 10-year increase of 6 percentage points from the mid-1990s. In the same
time span, real residential property prices have dropped by almost 20 percent. In other words, home
equity has been dropping significantly since the 1990s and this is also the key reason behind the lack of
Private Consumption Growth in Japan ever since. With condominium prices now finally beginning to show
upward momentum (approximately up 20% in the past two years), Japan might again prove to be the
ultimate contrarian investment.

Unfortunately, the only consumption growth experienced by Japan since the 1990s has been concentrated
in the government spending. The Japanese government in terms of the Ministry of Finance and the Bank
of Japan has been looking at the economy through the greasy Keynesian glasses for decades, but with
the reforms initiated by Koizumi it now looks like a new era might be taking place. The privatisation of
the Post Office, the deregulation of the financial industry and the debt ceilings were initially regarded as
a pitfall for Koizumi, but these reforms proved to be popular courses.

The fact that inflation is creeping higher in all countries surrounding Japan, could finally make the BoJ
move rates towards normalisation. In our opinion, we will see three hikes in 2008, taking rates to 1.25%.
That might in itself be enough to push the JPY higher in FX markets. Such a change in interest rates does
not seem like a lot, but it might be enough to take JPY higher (see the FX section) and thereby punish
the Carry Trading Housewives of Japan. In other words, capital flows might revert and benefit Japanese
assets. Japanese stocks and home prices (but not bonds) will see increasing support from capital flowing
into Japan rather than out.

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saxobank: Outlook 2008 Year of recession

Energy in 2008: Oil Prices Could Double Again

to 175 USD/barrel

It’s becoming a yearly tradition to call energy prices higher – so if the prediction ain’t
broke, then we’re not about to fix it. We think oil prices could nearly double again in
the coming year – despite our outlook for slowing developed economies.

Last year we were expecting upside risks to outweigh downside risks and for oil prices, while they might
temporarily ease, to possibly spike dramatically in 2007. This proved to be the case, as spot NYMEX crude
dropped to nearly 50 dollars before rocketing to 99 dollars and change. But rather than pat ourselves
on the back with our prediction, we were surprised to see that, of the mechanisms that actually drove
oil prices higher, we had only predicted a couple of the most obvious. In other words, while we got the
direction right, we got some of the key reasons very wrong. This year we again take a look at the upside
risks for oil, as we expect many of the current drivers of higher energy prices to continue to drive prices
higher in 2008. We also have a look at a few potential downside risks that could ease the pressure on
world oil prices if we’re wrong.

Booming demand in oil exporting economies

As oil prices have risen dramatically, oil exporting countries have seen an unprecedented economic
boom. The enormous injection of capital into their domestic economies has dramatically increased energy
consumption as their economies swell, and these economies now have some of the highest growth rates
in energy consumption in the world. (Consider Saudi Arabia, which exports approximately 6 million barrels
of oil a day. At an average price of 70 dollars, say, that puts the value of their oil exports at over 150 billion
dollars annually). And their consumption is increasing far faster than their production, which in many
instances isn’t increasing at all any more. Since 2000, for example, oil consumption in Saudi has risen over
50%, in Kuwait also over 50% and in Qatar over 100%. Consumption in OPEC’s second largest producer
Iran (which is heavily subsidised by the government through absurdly low petrol prices) has grown by over
a third and exports could cease altogether within a decade at current consumption growth rates. Mexico,
one of the US’s most important oil sources, could stop exporting oil within 5 years as its production is
collapsing while demand is stable to growing.

Peak oil
This was one of the few factors we got right last year. Oil production figures show a world that is having
a hard time producing more oil. While it will take years to know definitively whether global oil production
has peaked, there are ready signs that oilfield depletion is beginning to outpace the production from new
discoveries. Light crude oil supplies have already peaked. According to Simmons and Co. International,
a mere ten of these old fields are still responsible for 17% of world oil production and all of those fields
face potential and imminent production declines. Production at the second largest field in the world at
Cantarell in Mexico, has seen production fall from over 2 million barrels per day in 2003 to an estimated
1 million barrels per day for 2008. Experienced geologists have got a hold of data from Ghawar, the king
of all oil fields, which is responsible for up to 5% of world oil production. Their analyses, published to the
likes of prominent peak oil website theoildrum.com, speculate that some of its most productive regions
may be entering steep decline already. If Ghawar is declining, world oil production must also be declining.
In fact, production for the most preferable light and sweet grades of crude is already in decline. Only

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increased heavy oil production and markets that haven’t put us into permanent oil production decline
overall are increasing production of heavy oil and oil extracted from natural gas fields called natural gas
liquids. The final frontier for oil, ultra-deepwater fields that were not technically feasible even a decade
ago, is also a factor. According to the IEA’s monthly world production figures, it looked as if May 2006
might have been the all time peak until we got a sudden pop in the data late this year that barely exceeded
that month’s total. (See the chart below) We wouldn’t extrapolate any future trend from this one data
point and we think that the potential is there for peak oil to continue to gain attention and to continue to
pressure world oil prices as supply simply cannot exceed demand.

Chart: Has oil peaked? According to figures from the IEA, it looked as if a peak may have occurred in mid-
2006 until recent data suggested that the world barely managed to exceed that total production figure.
But the moving average has turned flat and we may be at peak oil now – meaning that supply can no
longer grow.

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Emerging markets demand growth – particularly in India and China

Emerging markets are driving the lion’s share of new global demand growth. China and India are the largest
single examples of countries with booming economic growth rates, where per capita income increases
results in more energy consumption per capita. According to the US Energy Information Administration,
43% of aggregate demand increases, in fact, are expected to come from Non-OECD Asian countries
through 2015. So even if we get a slowdown in the developed economies, the continued growth in
the developing world will likely more than compensate. One interesting and possibly counterintuitive
phenomenon to watch: the Chinese may look for measures to cool their economy, and one obvious
measure would be to let the companies and consumers feel the full pressure from higher oil prices and
quickly remove remaining subsidies on gasoline as a way to cool demand. While this is theoretically oil
price bearish if demand is curtailed, it could actually increase the demand as the acute supply shortages
periodically seen when prices accelerate beyond the Chinese refineries’ ability to make a profit under a
price control regime ease and more products are allowed to reach the market.

Natural Gas: the Weather Joker

Natural Gas markets are largely local as gas can only be transported over the longest distances through
expensive liquefaction and movement by ship. Among the natural gas markets, the US could be the most
vulnerable if even a normally cold winter and/or an especially hot summer in 2008 finally breaks the
miraculous string of mildness seen in recent winters and summers in key gas consuming regions.

The Usual Suspects

We won’t go into detail here, but we have to consider the usual suspects of ad hoc risks out there
that could suddenly aggravate the already tight market fundamentals. These include the risk of a bad
US hurricane season after two remarkably quiet years in a row, and any number of geopolitical risks,
including events in Nigeria, Iraq, Iran and even Mexico (where we saw terrorist attacks in 2007 on energy
infrastructure by separatists.)

Downside Risks
Any fair assessment of a market requires that we consider the factors that might prove us wrong in the
year ahead. Here we have a look at factors that could unexpectedly counter the bullish case for energy
markets in 2008.

Worse than expected global economic malaise. We expect energy demand growth in the developing
world in 2008 to outweigh any demand drop in the developed economies (German oil consumption is
10% lower than it was 10 years ago, for example, despite overall economic growth) as these countries
continue to post strong growth rates, even if less strong than in the recent past. If a worse than expected
global malaise develops, demand may ease just enough for negative sentiment to drive prices lower than
expected. We give this scenario low odds, however. And before we get too bearish on the demand side,
consider the chart below, which shows US vehicle miles traveled since the great depression. 70% or more
of US oil consumption is destined for transportation. From the chart below, the vehicle miles traveled
development has barely seen a hiccup since World War II, despite the episode of 1000% increases in oil
prices in the 1970s and recessions.

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Sources: US DOT, Federal Highway Administration US Census Bureau

A stronger USD: Part of the rise in oil prices in recent years has justifiably been attributed to the fall of
the USD, as the dollar index fell over 11% in 2007 at its worst levels. (Oil prices have risen far less in non
USD terms, up to 20% less in some emerging market currencies in 2007, for example.) If the USD stages
a stronger than expected recovery, this might not single-handedly trigger a sell-off in crude, but it could
serve as a brake on rallies.

Financial Market Risk: On a week to week basis, this represents perhaps the largest risk to the energy
bulls. The price of any market is controlled by sentiment and need to trade vs. the market’s actual liquidity.
Any dramatic move we see in risk aversion and/or negative sentiment related to equity markets and growth
prospects could have fund managers of many stripes reigning in their long energy positions temporarily.
So market volatility could increase periodically to the downside on any dramatic move in risk aversion.
But we feel that these kinds of distractions in financial markets will only present excellent opportunities
to buy the dips.

We like crude oil in 2008

Our strategy in energy markets for 2008? We would take a core long position in oil as 2007 draws to a
close and add a bit on dips opportunistically. With the backwardation in the market, one might look to hold
December 2008 futures, which trade at a 4 dollar discount to the spot month at present and are plenty liquid.
We would also look to take a small position in September Natural Gas as we feel the natural gas market could
be ripe for a supply surprise if weather finally doesn’t cooperate this year. Best of luck in 2008.

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Agricultural Outlook 2008

2007 was a year with ever rising prices across agricultural markets. With wheat, corn, crude and milk prices
hitting all-time highs (just to mention a few), we are definitely up for an exciting market through 2008. The key
words will be volatility and uncertainty. When markets trade on all time highs there is from a technical point of
view great room for downside corrections - but on the other hand, these markets have been forced higher on
misbalances in the supply-demand relationship. With China still going strong and the economy staying afloat
in Emerging Markets, we don’t see any immediate correction or slow down on the consumption side. The US
economy is expanding for the 6th consecutive year, however at a reduced growth rate. The weaker USD will
continue to attract foreign buying, helping agricultural export and thereby keeping the demand high.

In 2007 poor weather in Australia, US and Europe reduced wheat output significantly, but measured on value
this reduction was more than offset by the higher prices. This continuous reduction of output in relation
to the lower planted area and the catastrophic 2006 harvest in Australia, means we are on 33 year low on
wheat inventories. The bioethanol case lured many farmers into planting corn (as this is main ingredients in
US produced ethanol) on expectation of high corn prices through 2007. There has been critical bioethanol
reports - showing very little environmental benefits and tremendous impact on world food prices, which hit
the poorest countries the hardest (E.g. demonstrations in Mexico as tortilla prices rose by 400%).

With this said we still keep a positive stand towards ethanol’s influence on agricultural prices through 2008,
but would like to add that going forward ethanol level 1 will not be the solution to global warming and CO2
emission problems. Corn gives a low output compared to the energy used in processing and transporting the
raw crop, while sugar which is used in Brazilian ethanol production give 5 times the energy output on the
same amount of raw material.

US milk prices reached record levels in 2007, as a direct result of high demand and lower output. Rising grain/
feed prices could also be part of the reason as farmers may have held back production per cow to keep costs
down. Expect prices to remain at a historic high level through first half of 2008 (between 16-18 cents/pound).
US milk supply will therefore be expected to increase into 2008 as a result of the latest price development.

US corn planted acreage rose 19% in 2007 compared to 2006 as farmers speculated in higher prices due to
the link with ethanol. In October USDA estimated US corn output at a record 13.3 billion bushels. The ethanol
profit margin narrows in on increasing corn prices, since continuing high prices may reduce the production
growth and use of corn in ethanol production. This will have a negative price impact on corn which is
expected to trade lower into the first half of 2008. The main indicators for this price development will be the
USDA “estimated planted acreage report” released February/March 2008. This will give the market a more
firm indication on how the farmers will allocate the acreage in 2008. On back of the latest wheat prices, we
should expect to see more allocated acreage into wheat production as farmers will try to benefit from the
historic high price level on wheat. The low inventories will further be hurt by the poor yields out of Australia
and Canada. We should expect high wheat prices at least until the new crop hits the market around June-July
2008. On good growing conditions and favourable yields this could be the event triggering a sell off.

Soybean output is estimated to come out 19% below the 2006 level. This output reduction is a direct result of
lower planted acreage and reduced average yields. In 2006 US farmers planted 15% less soybeans due to the
focus on ethanol. The market could go from record surplus inventories (573 million bushels, Sep 2007) to tight
supply into the spring/summer 2008 (expected around 215 million bushels). The amount of soybean oil used
in biodiesel production continues to grow which will support prices even further. We expect soybean prices to
remain above 850.00 until the new crop hits the market. In general, we remain bullish on agriculturals.

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Outlook for FX markets 2008

SEK and NOK to continue stronger
We expect the Scandies to show further signs of strength through 2008 supported by rates and
undervaluation in especially SEK.

Through 2007 we called both currencies significantly stronger especially against the dollar and now we
expect it is time for EUR to pay the price. The SEK has not been able to keep a sustained uptrend against
the EUR, which partly has been caused by lack of investors and a hawkish stand from Sweden’s Riksbank
compared to Norges Bank. One of the other key factors for NOK outperformance has been the elevated
oil prices which will further support NOK over the longer run. The correlation between oil and NOK has
been very strong through the last 2 quarters, which we explain by investors’ belief that the price increase
we have seen this year in oil is caused from a scarcity bias along with strong demand from such countries
as India and China instead of just intermediate spikes in volatility. This should lend further support to the
NOK looking 2-3 years ahead.

Looking at the macro data out of Norway and Sweden and ultimately transferring that to a 2008 rate
outlook, we see rates outperforming the Eurozone. Growth remains firm and with tight labour markets and
high resource utilisation and headline inflation figures remaining elevated we expect the Swedish Riksbank
to hike to 4.50 by Q2 and Norges Bank to hike rates to 5.50%. The strong labour market signalling further
wage growth leading to strong consumption remain the key factor for our rate outlook to be validated
in 2008. Key downside risk to our present view remains a much larger impact from the financial market
turbulence which could send EUR as a safe heaven currency giving sharp sell-offs in the Scandies.

We look for EURSEK to test 8.80 and EURNOK to test 7.75 by Q4 2008.

AUD and NZD reaching cyclical highs in 2007

These two currencies look to have topped out both from a rate outlook and for investors’ risk appetite.

It became very apparent that starting this year in July, both AUD and NZD could be seen as the FX barometer
to global risk aversion and sustained increase in volatility. Both of these are key themes along with funding
costs that make us believe that little upside is to be found for these two currencies in 2008... But with
AUDNZD to return higher, as the NZD remains more vulnerable to the above mentioned themes.

We look for rates in Australia to have topped out at 6.75%, concerns about credit market conditions and
US growth (being Australia’s largest investment partner) should cap it through Q1. And with both declining
house prices and retail sales and inflation running at 1.9%, and RBA having a 2-3% target band, this gives
them enough lead-way (along with headaches from the above mentioned issues) so that rates should be
capped, giving this carry trade a hard time not to depreciate in 2008 especially against the CHF. Our Q4
forecast for AUDUSD is 0.76 which is relatively aggressive compared to other investment banks. The risks
to our present view consist of elevated base metal prices and changing growth outlook for Australia to be
more a focal point towards the Asian region could give some support that needs to be priced in 2008.

The NZD remains extremely overvalued going into to 2007 and we think it’s the year for a more firm
deterioration of the Kiwi with not much going for it in 2008. We believe that RBNZ has peaked rates

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at 8.25% and their shift towards an increased focus on core inflation as other central banks have done
through 2007 (we do not condone this way of analysing inflation) suggest further evidence that the
present rate cycle has come to an end. Net foreign bond holdings looked to have peaked at 74.3%. This
has been a very valuable indicator for coinciding a top in NZD with a lacking factor of approximately
6 months. The country has seen significant slowdown in house sales. And with both retail sales and
confidence readings decreasing together with a strong belief that the economy has not fully felt the last 4
hikes leading to slowing domestic demand, Kiwi looks ready for a strong sustained downside correction.
Also with inflation for Q3 YoY now running at 1.8% there is room for the RBNZ to act when they feel it
is appropriate, which we believe will be sooner rather then later. Our Q4 forecast for NZDUSD is 0.62. We
had NZDSEK as a favorite last year, it would not have paid out carry adjusted, but we still think this is a
pair that could go 8-12% lower through 2008.

CAD to loose strength through 2008

The Canadian dollar was one of the big gainers in 2007 and our forecast for USDCAD to reach 0.9600 in
Q3 was reached.

We saw an abrupt change in CAD strength in the start of Q4 and we believe that the 2007 lows in
USDCAD will be the extreme in CAD going forward into 2008. We got mixed view on the Canadian
dollar because the macro data remains firm, but external factors such as the Canadian Finance Ministry,
BoC and risk aversion has given the CAD a hard time. Fundamentally there is still much to feel good
about. Unemployment saw a 33-year low this year and growth remains above trend. Also CAD should be
supported by high oil prices in years to come. But on the other hand, we have seen Canadian trade data
shrinking on a month on month basis and the continued fears of a recession in the US which receives more
then 90% of Canadian exports, along with the outcry from Canadian policy makers that CAD strength
is “too excessive”. Their central bank cutting rates 25 bps has lead investors to believe that risk is too
great to remain long CAD to this extent. And to a certain extent we agree, but looking at just the macro
part, Canadian rates remain relatively low analysing 2007 data, along with the central bank cutting rates
when inflation is running at 2.40%, which is above their comfort zone. So yes, we think the strength is
to extreme, but there is risk the USD doing better then expected, sending BOC on a bumpy ride for 2008.
Our Q4 forecast for USDCAD is 1.0600, with the potential for the currency being sold the heaviest
against the CHF. But for commodity currencies we still expect CAD to outperform AUD.

Our GBP 6-month view remains clear but…

We have a clear vision of rates going lower through the first part of the year, but with some upside risk to
inflation for the remainder of the year.

The pound has lost ground as the rate outlook has deteriorated through the last quarter. We believe that
5.75% is the high for now, but we expected the BoE to wait to January to cut rates by 25 bps. But worse
than expected money market conditions in the UK and local mortgage banks showing signs of trouble
that should not be taken lightly, we believe this had only to do with trying to ease the credit crisis; but
it has done little to change spreads over policy rates. So we take a bearish stand through Q2 2008, with
a more slowdown in the housing sector along with private consumption and lingering worries from the
large financial sector. This is a currency that has been supported by high rates and inflation, running above

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their central bank targets through a good part of 2007, which now looked to have vanished. So another
25 bps cut in Q1 seems almost certain and likely another cut in Q2 to continue to send GBP TWI on slide
through the first part of 2007. But risk to inflation remains very real in 2008. BoE mentioned in their last
statement that headline inflation should be considered as real threat (which goes along nicely with our
view that rising energy costs and food prices may keep rates relatively high by Q4 2008) suggesting that
some comeback could be in the cards. Also in general there is an upside risk to inflation; this is that the
large impact that the money markets are having in the financial sector will continue to persist through
all 2008. Our Q4 forecast for GBPUSD is 1.90, with CHF being a potential big gainer against the
pound through the first half of 2008.

CHF finally looks ready to leave its label…

Despite most market participants liking the CHF, it has not been able to leave its funding currency label,
but 2008 and could help it move in the right direction.

Most investment banks once again made too bullish calls on the CHF, but we believe that this could be
the year that finally brings some CHF strength from something else then USD deterioration. With rates
now at 2.75% and conditions looking more “normal”, with 3 month Libor trading just above central rate,
the CHF should remain supported in the present credit turmoil also supported by its large current account
surplus, which should favour the CHF if global imbalances is to unwind. Q4 inflation has picked up along
with strong retail sales over the past 2 quarters which was noted by SNB at their last meeting. At the
same time Roth (SNB) has made it clear on numerous occasions that SNB remains concerned about the
inflationary consequences of a persistently weak CHF. And with growth remaining above trend we think
it is reasonable to see a rate hike by the SNB in Q1 of 2008 favoring the yield differential to the euro.
Downside risk lies in that 50% of exports goes to the Eurozone which means that SNB may have to lean
more up against the ECB rate policy then they would like too and to the fact that the economy’s large
exposure to the financial sector that may come to play a role if the bank crisis continues dwell. Our Q4
forecast for EURCHF is 1.53.

A rise in JPY should come from further risk aversion

We are not at all impressed by the 2007 macro data out of Japan (putting little pressure for BoJ to
consider further rate hikes in 2008) but inflation may be imported from the other Asian economies.

The JPY has appreciated since the beginning of the sub-prime crisis that really started taking off in the
summer and we continue to see this as the dominant factor if JPY is to continue its gradual appreciation
(along with continued elevated volatility). We don’t see it at least for the first 2-3 quarters as having to
do with JPY strength from a fundamental standpoint other then the fact that Japan continues to have a
healthy current account surplus which would be supportive if the global imbalances are to unwind.

Looking purely at the macro side of things, the Q2 growth was out at -1.2% revised down by a significant
revision to the capex, in which in the past has proven to be supportive for the Japanese economy. We
expect growth to be back in positive territory through 2008, but with inflation at 0.3% it is difficult to get
excited about Japanese macro data for possible rate hikes in 2008. On a positive note is the tightening of
the labour market, which ultimately should lead to a pick up in consumption, which we believe to be the

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saxobank: Outlook 2008 Year of recession

key trigger for real JPY strength in the later part of the year, taking aside risk aversion. Our Q4 USDJPY
forecast is 111.00 with the real potential lying in EURJPY where our Q4 forecast is 149.00.

EUR: The 2007 steamroller looks to be running out of gas

2007 was definitely the year for the EUR, but we expect – despite economic conditions remaining firm –
that we have seen tops both against the USD, CHF and JPY.

As we said we still like the EUR, but our fundamental view has slightly deteriorated as growth has likely
topped out for now, along with a further softening of the unemployment rate. We believe it is time for
other currencies to shine through 2008. Also any real upside move in the EUR in Q1 would likely lead to
increasing statement from various European officials bringing intervention once again to the table as we
saw when EURUSD broke the 1.4900 barrier. Also the slowdown in exports to both US, Asia and Eastern
Europe would help support the above mentioned statement. From a rate perspective we expect the ECB
to take rates to 4.25% in early 2008 throughout Q3 of 2008 as inflation is running at 3.10, which doesn’t
fit their target zone. Upside risk lies in headline inflation which we mention as the key risk throughout
2008 for major currencies. We still expect to remain on for now as Trichet does not give the impression
that challenges concerning the credit crisis is near its end. We have done very little to our EURUSD forecast
since January 2007 as we have been convinced that the decoupling theme from US is not going to happen,
as history will repeat itself and the overvaluation that we presently see against the USD, CHF and JPY will
gradually decline through 2008. Our EURUSD forecast for Q4 is 1.3400, please under JPY and CHF
for Q4 forecasts.

The dollar outlook remains uncertain, but…

USD consensus remains too negative in our view with the present data at hand; we see the biggest
potential disappointments in the Eurozone.

We have definitely seen a deterioration of the US economy over the past 2 quarters, but growth, spending
and employment still seems too firm to talk about recession going into Q4 figures where downside risk to
growth is present from after-shocks in the financial industry. There is also still a chance for additional rate
cuts, but FX traders should be more concerned about the rate differentials vs. other currencies. To us it
seems like the worst has already been priced into the USD.

Another factor, that might prove to be very important for the USD is liquidity-need flows from corporate
America’s overseas operations. Like in 2000-01 when the US economy went into recession last time and
the equity market collapsed, the USD might stay strong for the simple reason that businesses need to
consolidate their liquidity. They can only do this by selling for example EUR or GBP denominated assets and
buying USD denominated ones. This mechanism might even be more important as the credit crisis unfolds,
since the result is tighter financing conditions and more demand for liquidity.

So all in all there is certainly mixed signals, but we still think the US will beat the negative consensus bias
and in general make a comeback against the overvalued EUR and other European currencies.

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saxobank: Outlook 2008 Year of recession

Growth engines charging from East

Structural reforms, that range from added transparency in the dealings of the Russian central bank
to Chinese equity markets opening up to foreign investors, have and will continue to make emerging
economies attractive destinations for international capital flows. As the emerging market portfolios
become increasingly diversified, the intra-emerging asset correlation is being drastically reduced, effectively
limiting the probabilities of chain-linked emerging market crisis the likes of which were still experienced
in the late 90s.

The rising crude prices and ever growing demand for construction and infrastructure materials have not
only created new opportunities for the emerging markets that export resources but have also turned many
of the same economies into largest users of natural resources: The Russian economy has virtually exploded
on the back of oil and natural gas exports, making Russia the third largest holder of international currency
reserves behind only China and Japan. Forecasted growth levels for Russia into next 2 years trail around
7%, by far surpassing the growth estimates in all of the G7 countries.

The great equities bull ride in mainland China and in its extended arm of Hong Kong maybe nearing a
severe correction as the global downturn is set to take its toll on the Chinese exports and as the speculative
bubble in domestic stock markets looks soon to be burst. Nevertheless, the prospects for Chinese longer-
term growth are still intact and this continues to translate into continued demand for commodities in a
country that has seen its supply of commodities outpaced by demand since 2000.

On the other side of the world, Brazil, the giant of Latin America, has continued to grind forward: While
the growth rates have gradually climbed over 5%, the Bovespa Index is up about 60% YTD. As Brazil
is relatively well shielded from a US slowdown with less than 1/5 of its exports directed to US, and
as discovery of new oil reserves widens the range of opportunities this already resources-rich nation is
enjoying from, we see the Brazilian growth to continue into 2008, albeit at a more moderate rate.

Emerging building bricks beyond the BRICs

The success story of the rising emerging markets transcends the well-covered BRIC countries and leaps
to larger pool of countries, some which have been part of the global free market place for less than
two decades. In our earlier analysis, we singled out Czech and Slovak Republics as well as Poland as the
potential strongest performers in their respective peer groups and we maintain our positive outlook on
these countries going into 2008.

With real growth rates nearing 10%, Slovakia has virtually turned into “China of Europe” and this growth
has been – to a considerable degree – a product of robust domestic demand. Furthermore, the Slovak
growth has not come at the expense of a run-away consumer prices or weakening domestic currency. We
see the SKK tracing the appreciation already experienced in CZK in 2008.

The picture in the Czech Republic and Poland is very similar to that of Slovakia and the fact the Polish
zloty and Czech koruna have been the two best performing emerging market currencies this year clearly
illustrates this fact. We believe the PLN and CZK to continue their strong performance throughout the year
2008 and growth in both countries to outpace rest of Europe.

Our outlook on Turkey, one of the best performing emerging market participants of past 2 years, has been
somewhat cautious on the latter part of 2007 as the liquidity crisis and domestic slowdown have both
taken their respective. Having averted a larger military conflict and with a government that is bent on

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saxobank: Outlook 2008 Year of recession

accomplishing the necessary reforms to carry the country into EU and boosting continued positive FDI and
capital inflows, however, we are gradually changing our outlook to positive, while still exercising caution
in longer-term long-TRY positions during 2008.

In contrast, with a Current Account Deficit that runs around 12% of this year’s GDP (Q1 through Q3),
and contracting capital spending and M3 money growth that runs around 60% despite key rate targets at
13.75%, Iceland remains highly exposed to a disorderly correction in the emerging markets and reversals
of ISK-denominated investments. We continue to observe the capital and FDI flows to Iceland and view
the ISK with cautious outlook going into 2008.

Yield spreads growing between emerged and emerging markets

While the Federal Reserve has already blazed a trail with a 1% rate cut with more cuts possibly on the
offing, many of the G7countries have followed suit as if to comply by leading actions of US central bank.
The year-end easing by the Canadian bank, for example, seemed to stem almost entirely from external
factors and fears of rapid currency appreciation, more so than concerns of growth. Likewise, the ECB’s
reluctance to proceed with actual monetary tightening despite the earnest wage pressures and generally
hawkish public stance displayed by Trichet and 25 bp cut by the BoE after an entire year of a committed
non-inflationist stance and the BoJ’s fear of hikes, all add to complete a picture of the monetary path
chosen by the developed nations.

In stark contrast to G7 nations, several high-growth emerging economies have taken a more preventive
approach and embarked on policies of gradual monetary tightening: Poland has already taken its key
rates to 5% with more hikes to follow in Q1 of 2008. Hungary, likewise, has now managed to surprise
cut-expecting market players with a firm stance that looks to be extended as wage pressures effectively
tie the hands of central bankers.

Similarly, Mexican and South African central banks have already taken their policy rates to 7.50% and
11% respectively, and are likely to maintain their vigilant stance against the rising domestic prices. While
Turkey has lightly eased its already very high rates, we believe the rates in Turkey to remain above rest of
the emerging market rates in 2008.

Notwithstanding some of the price-driven central bank actions, the general direction is clear in that the
yield spreads are set to expand between the emerged and emerging countries and this yield differential
will enable the continuation of carry trading, albeit with increased volatility in riskiest assets, as discussed

Expect higher volatility in riskier investments

As repeated market experience has shown us, the high-beta, high-yield currencies of countries that suffer
from high unemployment rates and large current account deficits and are dependant on capital inflows to
cover those deficits. Currencies such as the Icelandic krona or South African rand continue to be exposed
to sharp and sudden reversals in risk appetite as the global economic activity inevitably slows going into
2008, further tightening the fund flows into riskier asset classes.

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saxobank: Outlook 2008 Year of recession

The below chart of the S&P/IFC Emerging Markets Composite index, encompassing all emerging market
equity indexes, illustrates the key points we have made here clearly: The growth in EM has reached an
explosive rate from 2003 with at a steepening yearly moving average. While the growth momentum is
clearly intact, the liquidity crunch experienced in August continues to pose a critical problem to emerging
markets, dwarfing many of the earlier problems and exposing them to potential periods of sharp risk
reversals and increased volatilities.

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saxobank: Outlook 2008 Year of recession

Equities 2008: At the very end of the cycle

One of the biggest changes throughout 2007 was the increase in volatility and consequently a widening of
ranges. In addition to widened ranges we also witnessed a big sector divergence looking at the US market,
namely Energy and Materials, outperforming S&P 500 by around 20% and in the other end Consumer
Discretionary and Financials underperforming by around 18%.

How equities will fare in 2008 will almost certainly be steered by which way the macroeconomical picture
unravels, with the macro view we have described above regarding a recession looming in 2008, if this is
the fact, equities on average will face a dreadfully tough year.

The key theme will be whether or not the FED with the recent rate cuts has or will avoid a recession. If
they have been successful bulls around the globe will rejoice as historically rate cuts that succeed in the
avoidance of recessions have been very positive for equity markets. Cheaper financing costs should help
margins, and with no economic halting EPS, growth should continue in a positive pace around 7-8%.
However, if the FED has failed, and our prediction of a recession comes true, it might be time to incite a
bit of doom and gloom, regarding equities. We will see sharp deceleration of earnings growth at year end
and moreover broader indices are likely to correct at least 15-20% on average.

One thing we will try to guarantee is that the change or rise in volatility is here to stay at least throughout
2008 and with that comes the significant ranges and relative sector divergences. We still prefer Asian
and European equities to American ones (excluding UK), and see sector weightings and geographic
preferences as equally important. Below we have highlighted a few sectors and geographical areas of
interest, describing how we see them fare in the maybe dire future of 2008.

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saxobank: Outlook 2008 Year of recession

Stick to Defensive Sectors

With a recession looming, which should dampen growth, we advise long investors to go defensive.

For those wanting to be long equities, investment in the more mature sectors with strong fundamentals
is important as is relatively cheap valuations and – not least – capability to grow earnings despite slowing
economic growth. These attributes are most easily found in healthcare, oil services, technology, insurance
and telecoms. We highlight the two we like the most; health care and oil services.

Although the political environment overseas still represents a bit of a challenge, which is subject to change
with a likely change of regime, health care and pharmaceuticals are both positioned for strong growth.
With plenty of room for multiple expansion and obvious demographic catalysts for years to come, this
group should outperform.

Regarding oil services, there’s extremely deep value to be had here, both in Europe and the US. With the
view we have described regarding energy prices, we see this group continuing to make impressive earnings.
Even with attention towards alternative energy rising, longer-term demand for drilling etc. remains firm.

Cyclical stocks, consumer-oriented and most financial companies will be underweighted by us, owing to
our cautious stance on the economic outlook.

The Support for US Military at an end - focus on Lockheed Martin

Declining support for war waging and possible change of regime should hurt US Military equipment

The last 8 years have truly been supportive for the US military sector; a lot of money has been channeled
into this since Bush took office in 2001 supported by a long war against terrorism. However, with the likely
change in politics through a shuffling of seats in the White House the torrent of money might come to an
end. We are highlighting Lockheed Martin as our prime pick for a short Military play in 2008. Looking at
the graph of Lockheed Martin below we surely see a change of regime opening up for some room to the

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saxobank: Outlook 2008 Year of recession

Alternative Energy
Political outlook and oil prices main drivers for positive growth in alternative energy.

We are positive on alternative energy; the sector is set to have another positive year. Aside from political
attention, alternative energy is thriving from the exploding oil prices; if oil prices remain at this level or
even higher alternative energy should be further boosted.

Wind energy is by far the biggest alternative energy source followed by solar energy. However, there is still
room for expansion as the current wind energy installations only cover around 1% of total global energy
usage. However, with the strong growth in alternative energy a lot of market participants have arrived
adding a stronger competition.

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saxobank: Outlook 2008 Year of recession

Bearish but neutral on financials

We still see a lot of trouble going forward but with a recession almost fully priced in, the risk/reward setup
is not ideal.

The financial sector should with our bearish view on the economy, be the easiest to predict. However, the
financial sector has been by far the worst performing sector in 2007. A recession is almost fully priced in but
we still see additional downside as we have yet to read the final chapter of the subprime tale, if that will ever
be written; however, the potential downside must be deemed somewhat limited. This sector by the already
priced in recession should be boosted the most by an avoidance of a recession thus we are taking a hands-off
approach for now.

Japan – Time to shine?

Even though Japanese equity markets have been a living nightmare for long-only investors the last 2 years, we
believe that expectations for earnings in growth are overly pessimistic. We might see further weakness, but we
will buy when Nikkei 225 reaches 13352.

There are several reasons pointing towards this. First of all there we could compare the currently traded P/E
for Nikkei 225 with the estimated P/E for next year. At least this should provide us with an indicative answer.
Currently Nikkei 225 is trading with a P/E at 28.69, while the estimated P/E for next year given the current
earnings level is 104.36. Second, nearly half of the listed firms are trading below book value and the dividend
yield has exceeded the bond yield. Third, we noticed with great interest that the only housing market that is
currently in an upward trend, however weak, is the Japanese. And the link between the state of the housing
market and the development in the stock market should, given the development in the US, now be clear to
most readers.

However, there are also some limits to this view – the macro headwinds and structural challenges facing the
market. In order to trigger higher returns, a number of positive catalysts would be required – such as: 1) A
domestic consumption recovery and 2) Domestic investor buying.

First, in order to create a domestic consumption recovery the Japanese companies needs to share some of their
wealth with their employees. One of the major thresholds for a consumption recovery is the marginal increases
in wages over the last years. There should be room for wage increases; companies profits have increased over
the last years, a total rise of 67% for the economy as a whole since 2002, while labour costs have been reduced
by 5% since 2002 as a result of retiring baby boomers. Even a modest narrowing of this gap could support
consumption and further out, inflation.

Second, we need increased buying from Japanese investors. In 2007, only non-financial corporates have been
buyers, while most other investors such as retail investors, investment trusts and financial institutions have
remained sellers. There is, however, a fair probability that investment trusts/retail investors will turn into buyers.
Given that equity dividend yields are now competitive with government bond yields, there is basis for increased
inflows into domestic high-yield equity investment.

Despite the risk factors mentioned we maintain that Japan will be a major positive investment story by year
end 2008.

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saxobank: Outlook 2008 Year of recession

China – Bubble bursting?

Looking into 2008 we continue to believe in China’s long-term macro and microeconomic potential.
However, we believe that we have come to a turning point where several risks are overshadowing strong
fundamentals. We expect a rather volatile path of returns for the Chinese equity market and we forecast
a potential correction of 40% for the Shanghai Composite, targeting 2900 year end.

There are several reasons for this scenario. First of all we believe that the RMB is likely to accelerate its
revaluation and could strengthen against the USD. We have lowered our forecast of China’s real GDP back
to trend line growth due to slower external demand and a continuing tightening stance from the Chinese
government. Domestic demand is back as the key driver for growth due to an expected acceleration in
private consumption relative to fixed-asset investment on the back of rising household incomes. However, the
inflation has become sticky. Food prices are on the rise again since second half of October and this pressure
is hardly going to disappear without aggregate demand cooling off first. So with rising domestic inflation
coupled with reversing interest rate differentials vs. the US, the potential gains from faster RMB appreciation
should be even more obvious to the Chinese policymakers. Consequently we believe this is the most likely

Second, there is an institutional argument. If the Chinese government is to release the ban on foreign
investments we will most likely see an outflow of cash to other equity markets. This will consequently provoke
a sell-off in Chinese equities.

And third, there is the Olympics aftermath. Even though we continue to believe the fundamental impact
of the Olympic Games to the overall Chinese equity market is limited, given that China is a large-scale and
diverse economy, we still think it will have an effect. We believe that investor sentiment could peak one or two
months before the Olympic Games in August, when investors may start to take profit. This is consistent with
what is previously empirically documented when looking at Olympic Games impact on local equity markets.

On the basis of the above presented arguments, we believe that the Shanghai Composite will touch 2900
year end 2008.

Agricultural products – prices keeps going up

We are positive on stocks related to agricultural production – that is the production of corn, wheat, and
animal products like meat and milk.

Prior to the last years’ development in prices in corn, wheat, milk and meat, most equity analysts were far
more interested in companies that were processing the input from the agricultural production. However,
we believe that due to the changing demand for meat in China and India and the ethanol driven change
in demand for corn in the US, focus should be stocks related to agricultural production.

The producers themselves are for most part privately owned. However, there are exceptions and we believe
that you should look for these companies as we believe their earnings will increase due to increasing prices
in agricultural products.

Furthermore, we also believe that the companies that are producing equipment necessary for agricultural
production will benefit from the increasing prices in agricultural products. Often increasing prices in products
leads to investment in expanding the production capacity and this will most likely happen in this case.

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saxobank: Outlook 2008 Year of recession

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